Brexit: Change, yes, but in the wrong order

Brexit: Change, yes, but in the wrong order

We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run. Roy Amara

So, you’re an expert on Brexit now?

No I’m not. I really didn’t want to write a blog on this topic. I’ve seen dozens of conference calls organized by brokers; hastily written notes from fellow fund managers; and legions of newspaper articles. All of them saying essentially the same thing: “this was unexpected; it is bad; and we have no idea what happens next”. So I was loath to add to my ignorance to the digital fish-and-chip paper pile.

But having fielded a number of calls from clients over the last two days, I reached the conclusion that this is probably a better forum to communicate with clients than answering each question individually.

I’m going to try and deal with this from a markets perspective, split into 3 sub-sections: a) What we know for sure has happened, that being the price moves that have taken place; b) what we think may happen where we now have some evidence and; c) What is mere speculation and thus should be given the lowest weight but has to be addressed.

And let’s get out of the way my personal opinion on the matter: having lived in the UK for almost 6 years and having many friends there still, some of whom are even brexiteers, my view is that it is an economic tragedy for the UK where living standards have been sacrificed for nothing tangible and the anger whilst real, is mis-directed. The NHS and housing suffer because they don’t build enough houses because of NIMBYism and where collectively the decision was made for fiscal tightening through contracting expenditure rather than through expanding the tax base.

In short: they shot the wrong person. For those who still believe the EU was a dead-hand to UK growth, please read this blog which walks through a short longitudinal study of UK data before the EU and post the EU versus Sweden and France.

And for those who believe it was worth sacrificing national income for “independence day” consider the Trans Pacific Partnership (TPP) Australia signed with the USA and the expansion of Investor State Dispute Settlement and the arbitration panels which sit, like the “loathed” European Court of Justice, unelected and outside out state sovereignty. It’s the price you pay as a small country to play with the big boys. You can decide if the price is too high, but there is no freebie from leaving the EU.

The country who should have left the EU was Greece last year, but that’s a blog for another day.

What happened for sure?

We now have three days of price action to digest across asset classes and a picture of positioning and outlook is emerging. In trying to quantify this event, we looked for a similar recent one as a starting point to gauge how investors react emotionally. The characteristics we sought were: I) Geopolitical not economic driven; 2) singular event, not rolling; 3) somewhat unexpected. The US debt ceiling debacle of 2011 fits a lot of those criteria. Figure 1 below shows the movement of the S&P 500 index up to the event and after it.

I have highlighted the 2 days before and the day after the event (the technical default happened after markets closed Friday night, so it includes the Monday)

The green line is trying to draw your attention to the fact that the lows of the period were made on the day. This is consistent with our experience in markets – “you don’t get paid for being late”, which translates into those who short the market after the news made nothing from sell and hold.

Figure 1 – S&P 500 index (July-December 2011)

Source:Bloomberg

Since we are living through a live experience right now, lets look how it is playing out thus far. It’s not perfect as the anticipation was the wrong way in this event, but here we sit on day 3 with the SPX trading at the same level as 2:30pm on Friday (AEST). This would be again consistent with the maxim that you don’t get paid for being slow or late.

FIGURE 2 – S&P 500 INDEX (FEBRUARY-JUNE 2016)

Source: Bloomberg

So whilst one may argue that markets should have gone lower, the reality of the combined wisdom of thousands of people and billions of dollars in the world’s largest market have decided this is seemingly enough for now.

And if one is to try and think about why this is so, it is because quite simply this has in the short run a minimal impact on the man in Nebraska. Brexit will be Page 1 today; page 3 on Friday and page 7 by next month as negotiations and jockeying drags on.

Quite simply very little has changed, so the market will return to focusing on the data, which has been decent in Q2 in the USA. Or conversely if the jobs data continues to weaken in the US, it will go down, but it won’t be because of Brexit, it will be because of the data.

The way this thesis is wrong is that there is “contagion” where European Banks start to seize up, ala Lehman’s. But again, this isn’t a real event like Lehman’s. This is the fear of a future event.

So our base case is the US market bottoms in the 1980-1950 range by the end of the week, with a chance it may have already.

WHAT MAY HAPPEN?

The definitive loser is the UK no matter what. In this case we expect the pound to continue to make new lows and perversely, the lower the better.

After all an external devaluation like this is vastly superior to an internal devaluation like what Ireland suffered through. The deeper the pound falls the more likely that they can escape a recession. The chart below shows 45 years of the GBP versus the USD. Purchasing power parity would suggest fair value of $1.45-1.65. Deeply undervalued would be below $1.20, so that would be a starting point. Extreme undervaluation is the parity range, as that would put the average income of a UK worker at $28,000 USD, making manufacturing extremely cheap there!

FIGURE 3 – USD/GBP EXCHANGE RATE (1971-2016)

Source: Bloomberg

On the other side we see gold as being a winner under a few scenarios. If Japan goes “Ultra QQE” and does helicopter money, then gold will be an ancillary winner. Likewise from more ECB or BOE easing. Conversely if I am wrong and contagion spreads swiftly, gold is likely to catch a bid. It also has the nice characteristics of already being in an uptrend before the event.

FIGURE 4 – GOLD PRICE (JUNE 2015-JUNE 2016)

Source: Bloomberg

Lastly, the idea of raising rates anytime soon have been put on ice for the foreseeable future. In this respect one country stands out as having the ability, desire and current form in cutting rates: Australia. With less than one cut priced in, if we are wrong about the world, then one could see 2-3 cuts in the next 18 months. On the other side it is hard to see the RBA hiking rates into this backdrop as a rising AUD will kill the financial conditions index for them, thus presenting a better asymmetric way to play a bearish view than just short equities.

MERE SPECULATION?

Ah, the most interesting, but least informed area for a view: the evolution of the geopolitical landscape. It would seem that the Brexit camp had no formal negotiating position nor manifesto, nor pre-arranged trade negotiators (a stat I saw was they will need 300 plus people to work on the 50 trade deals a country has in place).

My guess is that with no PM for 3 months, followed by at least 3 months of preparing a stance on all these trade agreements, will result in the UK keeping all existing EU regulations in place in exchange for common market access, with an agreement for some “working committee” to vet new regulations once a year. On movement of labor, that it stays free with another “working committee” that reviews immigration to see that it’s “acceptable” every 12 months. Yes Minister always had a ring of truth to it.

But to return to the quote I chose to start with, make no mistake about it, the long term consequences (I’m defining 10 years plus) of this move are very real and will most likely be looked back on as the official start to the end of globalization. The above patch-up won’t placate the disaffected forever, as their problems were never the EU.

THEY ARE COMING FOR YOU

I wrote a short piece for a potential client as part of an exchange of views. This one happened to be on globalization. I will link to another page for those who want to read it. It was written months ago before Brexit (which I didn’t think would happen) and it is technical in parts, but covers off on what I see as the embedded weaknesses of globalization. And this is what Brexit was about in my view. Chances are if you are reading this you are the 1% and it is you who the anger is directed it. Let’s just hope it doesn’t end like last time, but history isn’t promising.